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The Stock Has Fleas but the Business Doesn't (PETS)
Posted by: Chasing Bruce (IP Logged)
Date: November 29, 2011 07:37PM

With online sales more than doubling from 2006 to 2010 and total sales growing more than 70% in that period, PetMed Express (PETS) was a growth investing community darling. However, the stock has since fallen from an all-time high of almost $25 in second quarter 2010 to recent prices below $10 as total sales saw a slight decline from 2010 to 2011. This qualifies PETS as a fallen growth stock and a current value play.

Description

PetMed Express (PETS) is a pet pharmacy selling prescription and OTC pet medications and other health products for dogs and cats direct to the consumer primarily through their website www.1800petmeds.com. The stock has been punished in recent months as Walmart (WMT) and other online competitors have made a push to enter the space.

This increased competition has resulted in slower growth and forced PETS to cut prices and increase buyer incentives in order to remain competitive. Price increases from suppliers have further chiseled gross margins, while operating margins have suffered due to higher advertising costs related to trying to fight off the WMTs of the world.

However, as the table below shows (source: company investor presentation), the pet medicine market as a whole is still dominated by veterinarians who have traditionally sold pet medications to customers directly. Veterinarians remain highly fragmented with limited pricing power, and should be even less able to pass along price increases than PETS and other retailers. In short: while WMT et al are clearly putting pressure on PETS, in the end PETS and the other retailers will be the winners while the vets will be the losers.


Why the Walmarts of the World Won’t Win Completely:

A recent survey by the American Veterinary Medical Association showed 56% of pet owners seek medical care for their pet based on price, and 26% are always looking for less expensive options for veterinary services and products. While WMT can definitely undercut PETS on price if they choose to make pet medicine a loss leader, this is unlikely as pet medication is not a frequently purchased item that will drag shoppers into the store on a weekly basis like milk or eggs. Beyond this, PETS will be able to offer more attractive pricing as will any internet retailer competing against a brick and mortar store.

Additionally, according to the same survey, 39% of pet owners look online for a diagnosis before visiting a vet. PETS is well positioned to capture business from pet owners attempting to find an Internet diagnosis both via their main website, and www.PetHealth101.com. PetHealth101.com is periodically updated with the latest research for pet owners covering behavior and illness as well as natural and pharmaceutical remedies for pet health problems. Beginning in fiscal 2012, the PetHealth101 content will be incorporated into the main website.

Furthermore, pet medical spending is growing. In 2009 there was $13 billion spent on veterinary care, with $10.9 billion on supplies and medications. Sell side estimates have the veterinary medicine industry growing at 5% a year over the next five years. Pet demographics closely mirror the human population in the U.S. and will thus lead to more opportunities for PETS in the future. Pets are living longer, requiring geriatric care and increased medical spending. This is leading to a wider focus by pharmaceutical companies that are developing drugs to treat more complicated and advanced aliments such as kidney failure and diabetes. PETS currently offers approximately 1,200 SKUs and has the ability to easily accommodate new entrants to the market place. WMT et al would have to sacrifice valuable shelf space in order to do the same.

Why the WMT Problem Is Likely Temporary

Traditional theory holds that pet spending is a recession-proof market. However, a recent survey from CouponCabin.com conducted in honor of National Dog Week (September 19-25) showed that 68% of U.S. adult dog owners said that economic ups and downs have no effect on their pet spending. That means 32% of adults do reduce their pet spending when the economy weakens, and they likely have over the last three years.

The average order for a PETS customer in fiscal 2011 was $79 (down from $82 in 2009). I believe that against a weakened economic backdrop where cash is tight, consumers have been backing away from an almost $80 order at PETS in order to just buy the minimum that they need to maintain pet health for the immediate future at WMT.

Is PETS a Good Business?

Despite the slowing/declining growth trends for PETS, it is an excellent company that will provide ample rewards to the shareholder that can weather the temporary disruption to the story. With little or no infrastructure, capex and R&D, the company can remain profitable on skinny margins.

A Dupont examination (net profit margin * asset turnover * equity multiplier) shows that even with continued net profit margin pressure down to 6.5% from a current level of 8%, ROE can still equal 17.4%. Similarly, if sales continue to slow resulting in a lower asset turn, ROE can remain robust: clearly a great business (TTM numbers).



Valuation

I don’t know what PETS is worth.

What I do know is that there is still plenty of room to grow versus veterinarians and that the company has extremely little capex, enabling it to continue to generate free cash flow despite pinched margins.

With no debt, and approximately $60 million in cash and short-term investments the company trades at an EV/TTM EBIT under 5x and a EV/T12M FCF multiple of 10x.

Both are extremely low multiples for a business of this caliber.

With a current market cap of approximately $190 million, a quick glance at a series of reasonable FCF multiples will give an idea of what the company could be worth when the market realizes that WMT will not wipe PETS off the planet.





The Kickers

It will take time for the market to realize that PETS will not completely lose to WMT. A shareholder friendly management will pay you to wait.

The balance sheet is rock solid with nearly $60 million in cash and short-term investments and $0 debt. The company has been returning this cash to share holders via:

1) A .125 dividend/share in recent quarters, resulting in a dividend yield greater than 5%.

2) A series of share repurchases, with the most recent being announced on Aug. 1, 2011 for $20 million. This is the fourth $20 million repurchase plan that the company has announced.

It should be noted that these share repurchases have been offset by the “1998 Stock Option Plan” which allowed for the distribution of 5,000,000 shares of common stock from 1998 through July of 2008. All 5,000,000 shares were awarded to employees. Additionally, the “2006 Restricted Stock Plans” allow for the awarding of 1,000,000 shares to employees (481k shares remain unissued) and 200,000 shares to be awarded to directors (78k shares remain unissued). These plans expire in 2016.

At prices around the $10 level, where the stock has remained since the announcement of the most recent buyback plan, the company could repurchase 2 million shares, or approximately 9% of shares outstanding.

Other Pet Products

In 2010 the company began to offer pet supplies via its existing website which are drop shipped to customers by third parties.

Cutting out the Middle Man

Traditionally, pet medicine manufacturers have declined to sell to PETS directly, forcing PETS to purchase its products from third-person distributors. PETS has been working on establishing direct relationships with manufacturers, and in March of 2011 Bayer became the first manufacturer to deal directly with retailers. If other manufacturers follow a similar course PETS may experience margin growth. However, as PETS is already in a price competitive environment, I would expect any direct access savings to benefit the end user rather than PETS and other retailers.

Ad Spending

Ad spending is the largest expense for the PETS outside of COGS. Their traditional spending is focused on television, online marketing and direct mail.

This is an area that I think the company can vastly improve in. The company measures the effectiveness of their ad spending through “customer acquisition cost” which is calculated as ad spending/new customers. Acquisition costs for 2011 rose to $42 per customer from $36 in 2009 and $34 in 2010.

While recent sell-side research predicts a weak ad spending environment through 2012, allowing PETS to maximize its ad dollars in a favorable spending environment, I would really like to see a more innovative customer acquisition strategy.

Diapers.com (private, and then acquired by AMZN) is an interesting case study. While I don’t have access to hard data due to the fact that Diapers was private at the time, they were able to quickly and efficiently grow their foot print through an email referral program that allowed existing customers to refer friends, etc., to Diapers.com via an emailed coupon. If this friend then used the coupon and became a new customer, the customer that referred the friend would receive monetary credit for their referral.

In this way, existing customers were incentivized to recruit new customers, and were made more likely to become repeat customers as they accumulated credit through their referrals. With a fiscal 2011 average order size of $79, the company could offer a 20% off coupon to new members and an approximately 10% credit to the referring customer and still come out far ahead of the $42 per customer acquisition costs recorded in 2011. Of course there would be a cost associated with developing the technology to do this, but at a glance it seems as if this would pay for itself in short order.

Risks

While in theory PETS should be able to compete well on price against any brick and mortar retailer, if WMT decides to position pet meds as a loss leader, there is not much PETS can do.

Additionally, while I believe that the 1-800-PET-MEDS brand has value, there are few barriers to entry and there have been recent entries to the space including heavy weights like AMZN and smaller online participants like Drs. Foster and Smith.

Catalysts

Strong buy backs, history of dividend hikes, continued cash generation, potential M&A.

Disclosure: I am long PETS. This is not a recommendation to buy.

www.chasingbrucegreenwald.com


Stocks Discussed: PETS, WMT,
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